A warrant is an agreement establishing an option to purchase or sell a security, cash commodity, forward, futures contract, swap, or other contract or instrument (“the “underlying”) which is the subject of a derivative contract or instrument at a given price and time or at a series of prices and times as outlined in the warrant agreement. A warrant differs from a put or call option in that it is ordinarily issued for a period in excess of one year. Warrants may be issued alone or in connection with the sale of other securities, as part of a merger or recapitalization agreement, and, occasionally, to facilitate divestiture of the securities of another corporation.
A covered warrant is a stock, basket, or index warrant issued by a party other than the issuer of the underlying stock(s) and secured by the warrant issuer's holding in the underlying securities or the warrant issuer's general credit standing. Ordinarily, exercise of a common stock warrant sold by the issuer of the underlying increases the number of shares of stock outstanding, whereas a call or a put covered warrant is an option on shares already outstanding. Covered warrants are often issued by investment banks when transfer of the underlying security is temporarily or permanently restricted, when traditional warrants are not available, or when buyers want security and currency warrant combinations not otherwise available in the market. Covered warrants may also be referred to by other names such as synthetic warrants and third party warrants.
The structure of a covered warrant typically ensures that holders will always have a ‘long’ position, be it with calls or puts, such that the maximum loss is confined to the premium paid. Generally speaking, if the underlyer is stock or Government securities, the settlement of the covered warrants can take place, consistent with what is indicated in the prospectus, by means of physical delivery of the underlying asset or through monetary payment. Covered warrants on other categories of underlying assets, such as index warrants, may be cash settled.
The underlyer permitted in a covered warrant structure may be regulated and restricted by the jurisdiction in which the structure is offered. For example, it is uncertain whether Japan's Securities Exchange Law (SEL) permits a covered warrant where a foreign exchange rate acts as an underlyer. Although covered warrants using FX rates as direct underlyer have been offered in some jurisdictions, this structure may be inappropriate in certain jurisdictions as legal definition of warrants can differ by region. For example, in Japan, securities brokers can only sell qualified products under the SEL. Although warrants were permitted under the SEL following a December 1998 revision, the SEL defines warrants in very narrow scope compared with other jurisdictions. To be qualified as a warrant under Japanese SEL, the underlying assets should be either securities under SEL or indexes on securities basket. Therefore, it appears that warrants on FX rates or interest rates are not “warrants” in Japan and securities companies may have difficulties offering them. Moreover, in some jurisdictions, tax treatment are unfavorable for warrants on simple FX rates or interest rates as they are deemed as options. Also, some believe that, in extreme cases, unqualified warrants may be regarded under the SEL as a violation of criminal code which prohibits gambles. Thus, the requirement made existing product structures offering covered warrants on foreign exchange rate fluctuations in unusable in Japan. Other problems with warrant structures may exist in other jurisdictions. Consequently, covered warrant advantages may be limited in certain jurisdictions.